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A Rare Downgrade for Disney: What You Need to Know

BMO Capital breaks from the herd to sound a warning on ESPN and the movie business.

According to data from StreetInsider.com, shares of Walt Disney(NYSE:DIS) stock have been upgraded five times in the past two months, but downgraded only once.

Actually, make that twice.

This morning, analysts at Canadian banker BMO Capital broke from the herd to issue a rare downgrade for Disney stock. According to the analyst, Disney bulls are buying the stock "too early" -- and paying too much -- because Disney is due for a fall. BMO now rates Disney stock an "underperform," and predicts the shares will fall to $88 within a year.

1. A flat year for Disney

Disney had a pretty lousy year in 2016, entering the year at $106 a share and exiting at $105. In between, the stock slumped hard before beginning a turnaround in October -- but thanks to that turnaround, Disney stock has zoomed 19% in price over the past three months.

Problem is, BMO thinks this turnaround in sentiment is coming too soon. According to the analyst, "ESPN sub[scriber] trends" are not guaranteed to improve, and in fact, BMO says "we still see more negative data points than positive for ESPN." At the same time, despite all the enthusiasm surrounding Disney's revival and expansion of the Star Wars franchise, Disney's films segment is not guaranteed to earn the kinds of profits investors are expecting. "Studio estimates embed better performance per film," warns BMO, "which is a key risk" to Disney's stock's profits if they underperform.

2. Not everyone's anxious

Now, it's important to note that BMO's opinion is not a popular one. Just yesterday, in fact, Goldman Sachs came out with a positive endorsement of Disney stock. Quoted on TheFly.com Tuesday, Goldman called Disney's 2018 film slate "the best ever," and predicted that a banner year for the studio unit will accelerate profits growth at the House of Mouse. Next year, Disney is expected to release no fewer than two new Star Wars movies, three animated features, and four separate Marvel flicks.

3. Why so glum, chum?

And that's not even the worst of it. According to BMO, while it's possible that if everything goes right for Disney, the stock could rise a bit from today's price, the best BMO thinks Disney investors can expect is a stock price of $110 per share by the end of this year. Conversely, the analyst worries that if things go wrong, Disney could even plunge below its own $88 price target, and fall as far as $70 -- a 35% loss from today's prices.

The most important thing: Figuring out who is right

So who has the better argument here today? Is Disney a $134 stock, like Goldman says? Or is it worth only $88 -- or even $70 -- as BMO fears is likely?

Here's how I look at the situation: Currently, Disney's share price of $108 values the entire company at a market capitalization of $171 billion. Weighed against that, the stock is currently earning $9.4 billion in annual net profit, but generating positive free cash flow of only $8.4 billion. This gives us a P/E ratio of 18.1 for Disney stock, and a price-to-free-cash-flow ratio of 20.4.

Given that most analysts following the stock only see Disney growing its profits at about 10% annually over the next five years, these prices do appear to be expensive -- the more so when you remember that Disney also carries about $15.6 billion in net debt, making its enterprise value even more expensive than its market capitalization.

Given this already high valuation, combined with the headwinds facing Disney's ESPN business, the strong dollar discouraging foreign tourists from patronizing Disney parks in the U.S. and encouraging U.S. tourists to travel abroad on their vacations, I think Disney will have a hard time outperforming the market in 2017. While I'm not sure BMO is 100% right about its disaster scenario of $70 a share, $88 does look likely. Accordingly, I'm siding with BMO on this one. I agree that Disney stock is probably a sell.

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Walt Disney. The Motley Fool has a disclosure policy.

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I like things that go "boom." Sonic or otherwise, that means I tend to gravitate towards defense and aerospace stocks. But to tell the truth, over the course of a dozen years writing for The Motley Fool, I have covered -- and continue to cover -- everything from retailers to consumer goods stocks, and from tech to banks to insurers as well. Follow me on Twitter or Facebook for the most important developments in defense & aerospace news, and other great stories besides.